Contributed by David Rudd, Chairman of Sigma Analysis & Management Ltd.
Background
Since the early days of “Risk Premia,” endowments and pension fund investors have tried to attribute alternative investment managers’ returns to a market subsector or phenomenon. Large investors have engaged quantitative shops like Sigma to decompose hedge fund returns, provide a better understanding of the risks in their investments and examine strategy divergence if applicable.
Astute investors realize:
1) In many cases, there is a market phenomenon (or premia) that accounts for much
of a manager’s returns;
2) One may be able to purchase the market phenomenon in the form of an index;
3) One could access a hedge fund manager’s returns with a managed account for a very small cash outlay while reducing risk, reducing fees and getting total transparency and liquidity. The cash efficiency available in the managed account has created a conundrum still facing institutional investors. This opportunity set, combined with risk premia, has encouraged a massive re-thinking of risk and return.
How Expensive is Cash Efficiency?
Managed account investors derive many benefits including more rational investment decisions, analyzing for beta, low cost access to the S&P 500 Index or derivative (5 basis points or less and zero cash outlay). As a result, a much higher bar can be set before allocating to illiquid private equity or stock picking. The use of derivatives is not an academic question. It is the lifeblood of excess returns, and in a less than favourable environment, it is the singular savior.
Why invest cash in trying to generate returns from equities when you can invest in equity indices without cash and get the same or better economic effect at lower cost? That isn’t a trivial question. It is the essence of the question every pension plan, endowment, family office and investor should have asked and answered.
The compunction to allocate dollars rather than risk is an extraordinary denial of the last 40 years of financial progress. If one allocates dollars, one is limited to the asset size of the plan and one takes on more risk than needed. If one allocates on a risk basis, one can build a risk-seeking, risk-complementary portfolio with better returns and lower risk. Investors have much more risk on their books than they believe. What rises together will generally fall together and investors understand this risk as never before. Asset-based investing is inherently much riskier than risk-based investing.
In the case of pension funds, if a plan is underfunded, or even if they want to stay fully funded, they must use cash efficiently. They must look to indices, and overlay cashless, complementary risk, and they really should use managed accounts. Any underfunded plan that buys private equity is consigning themselves to a continued underfunded status as that path chews up cash and leaves little flexibility. Any plan that doesn’t use managed accounts to allocate to a hedge fund is seriously undervaluing the opportunity cost of cash and may be seriously overestimating and overpaying for the unique skill the hedge fund possesses.
Prevailing pension plan investment orthodoxy is to match assets with liabilities. In an era where the future economic value of asset ownership is available without deployment of the asset, one must question this traditional orthodoxy of matching assets and liabilities. A risk-based approach looks at the world differently.
Moving to a Risk-Based Approach
Historically, investors are used to deciding an investment approach via an asset mix strategy. This is a deficiency in thinking. The major Canadian pension funds have moved very aggressively to a risk-based approach, rather than an asset allocation methodology. These and other large investors should seek to deploy return seeking exposures while at the same time, reduce overall risk.
Many of the pension plans who conserve cash via a risk-based approach are allocating that cash to private equity. However, private equity is illiquid, highly correlated to public equity and has a fee structure that is usually higher than most hedge funds. The viability of that premium is for a future discussion.
Conclusion
It has been a great run. From March of 2009 through May of 2018, the S&P 500 has quadrupled. From its pre-crash high in 2007-8, the index has more than doubled. It is time to think differently. Cash-efficient allocations enable investors to preserve risk, improve transparency and gain liquidity.
Prior published articles include: Investing at The Hedge Fund Saloon and How Pension Plans Can Improve on Approaches To LDI.
About Sigma Analysis: A firm of market professionals, mathematicians and data scientists. Sigma delivers investment solutions to Pension plans via custom built cash efficient, liquid and cost-efficient vehicles.
Ryan Nevin
Do you have any links or articles for what an ideal portfolio would be with a cash/risk allocation methodology v. an asset allocation model? I work in portfolio management so I’m curious to see what the differences would be. We manage to an asset allocation but also use tactical shifts from the strategic target to adjust for risk on each asset class. Thanks for the great article!